Softcat plc's (LON:SCT) price-to-earnings (or "P/E") ratio of 30x might make it look like a strong sell right now compared to the market in the United Kingdom, where around half of the companies have P/E ratios below 16x and even P/E's below 9x are quite common. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.
Recent times have been advantageous for Softcat as its earnings have been rising faster than most other companies. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. If not, then existing shareholders might be a little nervous about the viability of the share price.
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What Are Growth Metrics Telling Us About The High P/E?
Softcat's P/E ratio would be typical for a company that's expected to deliver very strong growth, and importantly, perform much better than the market.
Retrospectively, the last year delivered a decent 11% gain to the company's bottom line. The latest three year period has also seen a 23% overall rise in EPS, aided somewhat by its short-term performance. Therefore, it's fair to say the earnings growth recently has been respectable for the company.
Turning to the outlook, the next three years should generate growth of 8.4% per annum as estimated by the twelve analysts watching the company. Meanwhile, the rest of the market is forecast to expand by 16% per year, which is noticeably more attractive.
With this information, we find it concerning that Softcat is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. There's a good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.
The Key Takeaway
While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.
We've established that Softcat currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings aren't likely to support such positive sentiment for long. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.
It's always necessary to consider the ever-present spectre of investment risk. We've identified 1 warning sign with Softcat, and understanding should be part of your investment process.
If you're unsure about the strength of Softcat's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.